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ENTERPRISE RISK MANAGEMENT

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					    ENERGY
      INSURANCE
        MUTUAL
     19th ANNUAL
   RISK MANAGERS
INFORMATION MEETING
         The Westin Innisbrook Golf Resort
                   Tarpon Springs, Florida
               February 27 - March 1, 2005
Neil
Doherty
Frederick H. Ecker
Professor of Insurance and
Risk Management at the
Wharton School
DOCUMENT HOW VOLATILITY AFFECTS
               COPORATE VALUE
 1. Risk increases costs of financial distress
     (a). Ex ante: the prospect of distress can lead to conflicts of interest and
         dysfunction decision making
     (b). Ex post: distress involves transaction costs, loss of business
         opportunities, increased cost of funding, etc


 2. Volatile cash flows prejudice financing of new investments
     Most firms prefer to fund with cheaper internal cash
     Shocks to earnings can deprive firm of



 3. Risk introduces noise into accounting and economic numbers. Lack of
     transparency makes monitoring and valuation difficulties


 Each reason might call for different risk management strategy
RISK INCREASES COSTS OF FINANCIAL DISTRESS

  Costs of insolvency
    - Legal cost
                                  Probability
    - Regulatory costs
    - Liquidation costs


  Solutions
    - Reduce risk
       (hedge insurance)                        Debt   Firm
                                                       Value
    - Lower leverage
    - Structured debt –
       forgivable or reverse
       convertible debt
    - Contingent equity capital
RISK INCREASES COSTS OF FINANCIAL DISTRESS
          STRUCTURED DEBT TO REDUCE CREDIT RISK
                                                          (FROM CULP JACF)




         FIRM VALUE
                            Modigliani and Miller

                            FIRM VALUE




                      D/E     D/E                   D/E
RISK INCREASES COSTS OF FINANCIAL DISTRESS
             LOWER LEVERAGE LOWERS NEED FOR HEDGES

    Many studies (Dionne; Doherty&Klefner/etc) confirm that firms
     with lower leverage tend to hedge less
    After-event studies (Pretty; Doherty-LammTennant-Starks; Gron-
     Winton; etc.) : show that firms with lower leverage recover more
     quickly.
    However, these studies show that leverage is only a problem
     when firm value falls
    This points to the value of structured debt as a risk management
     tool. Lowering of firm value triggers derivative which un-levers
     the firm.
       - Forgivable debt
       - Reverse convertible
       - Warrants
       - Contingent equity
RISK INCREASES COSTS OF FINANCIAL DISTRESS
              STRUCTURED DEBT TO REDUCE CREDIT RISK
                                                            (FROM CULP JACF)
   Sonatrach – Algerian state owned oil producer
   Problem – Servicing Floating Debt – High Credit Risk – High
    Interest Charges. The particular credit risk problem is that they may
    not be able to meet high interest charges when oil revenues fall.
   Solution – Issue “Inverse Oil Indexed Bonds” – Raised Credit
    Quality And Lowered Cost Of Debt. Sonatrach wrote a 2 year call
    on oil with a strike of $23. Thus they would have to make payment
    if oil prices rose above the strike. In turn the counterparty (Chase)
    wrote a spread on oil prices (i.e., wrote a call and put) to the
    creditors who bought Sonatrach’s debt. Thus the investors had a
    long position in volatility.
     - Lowers cost of debt to LIBOR plus 100 basis points
     - Sonatrach yields some upside on oil to counter party
     - Investors accept long puts and calls – willing to accept this play on oil
         prices
 SONATRACH                                      Credit risk if oil prices fall


                          Floating rate notes
                             @ LIBOR+1



Writes 2 year call on
                                                               INVESTORS-
oil – strike $23
                                                               SYNDICATED
                                                                  BANKS
                                       Writes 7 year call on
                                       oil – strike $22

                        Writes 7 year put on
                        oil – strike $16

COUNTERPARTY
RISK INCREASES COSTS OF FINANCIAL DISTRESS
                                REVERSE CONVERTIBLE DEBT

    Convertible debt but conversion option held by firm
    Exercised when firm value falls
    Advantages
      - Anticipates workouts in which debt replaced with equity
      - Avoids bankruptcy costs (which would fall on creditors)
      - More closely aligns incentives of creditors and shareholders
          - Shareholders now have more stake in downside
          - Managers more averse to risky projects (no default option)
          - This will benefit creditors
    User ING.
    Form more common in Europe
      FUNDING POST-LOSS INVESTMENTS

 Graph shows the ranking
  of seven projects                    20
   - With low cost internal funding
                                       15
   - With high cost external funding

 With internal funding all            10
                                                             Internal
  seven projects have                   5
                                                             funding
  positive NPV                                               external
   - Total value created = 97           0                    funding

 With external funding                 -5
  projects 1-4 have
  positive NPV                         -10
                                             1 2 3 4 5 6 7
   - Total value created = 35
      FUNDING POST-LOSS INVESTMENTS
                  (CONTINUED) MERCK
 Merck was one of the first users of this RM strategy
 Research based Pharmaceutical company
   - Investment in R&D
   - Bringing new drugs through clinical trials and then to market
   - Predictable (?) investment budget

 Problem – large exposure to FX risk. Worried that sudden FX
  loss would deplete earnings. Thus Merck would lose cheap
  funding for R&D, etc., and would have to cut back on new
  investment

 Solution – hedge R&D risk to protect cheap funding
   - Note transaction costs of FX hedge fairly low
   - Would this strategy be as attractive for product liability risk where
      insurance transaction costs are high?
      FUNDING POST-LOSS INVESTMENTS:
                           SOLUTIONS
 Hedging
  - Secures cheap internal funding source; example see Merck

 Contingent equity
  - Example 1. Insurance firm fearing catastrophe loss sell put option
     on their own stock to counterparty. Provides cheap post-loss
     capitalization. CATEPUTS

  - Example 2. Cephalon drug company is taking drug through
     clinical trials. If FDA approval, it will need source of funding to
     develop the drug. Buys call options on its own stock.

  - Example 3. Michelin keeps high level of capital as war-chest for
     acquisitions. The cost of this capital is high and it can become a
     target. Solution contingent equity
FUNDING POST-LOSS INVESTMENTS: A
                   RELATED ISSUE
 Apache oil (member of EIM)
 Problem is that is creates value through acquisitions that
  are well priced and it has comparative advantage
 Hedging oil price risk allows it to lock in profit from
  acquisition which it gives a comparative advantage in the
  bidding process
 Hedge oil price risk with zero cost collar
 Also controls leverage to maintain financial flexibility so
  that it can fund acquisitions as they arise
 Candidate for contingent equity?
            RISK MANAGEMENT AS SIGNAL
 Risk management changes performance of a firm.
 Managed numbers can convey more, or less information
 Examples where signaling is important
   - Outside investors rely on accounting numbers to value the firm. Do
       “hedged” numbers convey more or less information
   - The profit or share price of a firm depends both on factors under the
       control of the managers and factors outside their control
         - Managers of an oil company can control the rate of extraction but
           not the oil price.
   - If the firm hedges the factors outside the managers control, then the
       remaining profit provides a better monitor of managerial
       performance.
   - Notice firm may be able to achieve the same goal by paying
       executives with indexed options
            RISK MANAGEMENT AS SIGNAL
CAN WE USE HEDGING MAKE EARNINGS MORE
     TRANSPARENT INDICATORS OF VALUE?
    Earnings = Base + Signal + Noise
    Signal persists but noise transient
    Investor cannot separate noise from signal.
    How does investor forecast next period earnings?
    Bt + (St + Nt)                        earnings @t


    (Bt + St)   + (St+1 + Nt+1)           earnings @t+1


    (Bt + St + St+1) + (St+2 + Nt+2)      earnings @t+2
NOISE HEDGING : FORECASTING EARNINGS


FORECASTING WITHOUT NOISE

B t + St                  earnings @t     RED LINE = EARNINGS
                                          BLUE LINE = EARNINGS W/O
                                                     NOISE




(Bt + St) + St+1          earnings @t+1

                                                                Time
                                                                       t   t+1
(Bt + St + St+1) + St+2   earnings @t+2
          RISK MANAGEMENT AS SIGNAL
 If purged of noise, then earnings become more
  transparent signals of underlying value
 Some evidence shows that when firms hedge, the
  responsiveness of the stock price to earnings
  surprises increases
 This leads to the interesting possibility that
   - Increased transparency can INCREASE the volatility of the
       stock price
   - If so, then stock options convey option to make earnings
       more transparent by encouraging managers to hedge noise
         WHERE IS THIS ALL LEADING?
 ERM starts with fundamentals
  - How does risk impact firm value?
  - How can management of risk preserve value?

 Three broad themes developed here
  - Risk affect the costs of financial distress
  - Risk can impede funding of investments
  - Risk affect the information conveyed to stakeholders

 There may not be one unified risk management
  strategy that hits all these points
 But it does suggest framework for ERM strategy
             BLENDING COST-OF-RISK THEORIES
                 AND TRANSPARENCY THEORY
               Leverage & Contingent   Mitigation   Hedging
                          Capital
               Contingent
               Leverage.
Signaling &                                         Noise / Non Core Yes
Transparency
                                                    Signal / Core   No


Bankruptcy     Yes         Yes         Yes
Costs
Disturbs       Yes         Yes         Yes
Investment
Decisions
Post Event     Yes         Yes         Yes
Financing

				
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